Formal economics used to be almost entirely devoted to issues of the allocation of scarce resources. A subset of inquires, usually called welfare economics, frequently explored how different allocative schemes affected economic welfare. Welfare, however, had a rather arcane meaning in formal economics because inter-personal comparisons were generally frowned upon in formal theory and applications. To get around the “dryness,” of such studies, economists adopted a compensation principle where by if at least one person was made better off and none worse off, then welfare was improved. This skirted the issue of “fairness,” or as some wrote about it, of “justice.” What if compensation by the winners was not paid to the losers after an economic policy change? A mere glance at today’s media tells us that issues of “fairness” rule the day, almost to the exclusion of discussions of efficiency. Social change is often motivated by issues of fairness and politicians of every stripe place fairness at the top of their choice menu. But, what is fair to one person, clearly could be unfair to another. Moreover, the achievement of “fairness,” brings with it economic costs. The latter are often ignored, but the consequences should not be. To truly be fair, we need to evaluate the cost of achieving fairness, however it is defined. This is the first of a series of notes that discuss aspects of the linkage between fairness and efficiency in political economy.
At a time when many fed-up voters in the UK seem to want to get out of the EU, it seems appropriate to use a Churchill quote to describe the utterly dependent nature that our Federal Reserve has chosen to acquire. Yes, we have a nominally independent Central Bank—that is to say that once the politicos have nominated and approved a member of the Board of Governors, they technically vow to keep their “hands off.” Of course, neither really allow a Fed to be independent, and it is hard to say that the shrill voices from 1600 or the Hill have no affect on the voting behavior of Governors. Who really knows how the Board comes to its conclusions? If you still think the FOMC is independent, ask the Regulatory wing of the Fed if it operates as a deaf mute!
That said, 50 years ago or so, the talk in US monetary policy debates among academicians and central bankers who seemingly agreed that a Central Bank had to be politically independent and should make its decisions based on the fulfillment of whatever chartering mandate it was given. Is it not strange, therefore, that the current FOMC finds that “international considerations” have now paralyzed its rate-making decisions? After a feeble 25 basis point (“bp”) raise in December, the FOMC has staggered and stuttered, looking around the world at what other enfeebled CBs are doing and has paused and paused and paused. Talk about ‘waiting for Godot.” Meanwhile, rate-starved fixed income holders now have the privilege of paying their respective governments in Germany and Japan for the privilege of making their savings available over the next decade. Nearly nothing for the insurance in Germany (3 bps) but 8 bps in Japan, a far cry from holding government bonds as a default-risk free investment with a nominal positive yield. Surely, they would have been better this year to buy Gold and stick it in a bank vault!
Meanwhile, for a Fed now fully engaged in the regulation of bank balance sheets in order to root out (still undefined) “systemic risk,” what has happened to independent monetary policies? The answer is quite simple. They no longer exist—and returns to Americans who wish to invest in default-risk free 10 year Govies are shrinking as well.
Oh, well—why not throw out everything we ever learned about monetary theory and policy? If such policies don’t work (according to the Fed), there’s no point holding on to them, is there? One might ask to be shown the theory that has replaced older thinking on monetary policy, but it is to be doubted that the question would even be heard in the board room at the Fed. It doesn’t seem like they have a theory that governs their policy making. Maybe they are too busy telling each other how they are preventing systematic risk via their new “stress tests.”
Well, why should central banking be any different from Health Care, Internet policing, Environment Protection, and Pharma Controls? We have entered the Grand Regulatory State—no point studying Macro anymore…it is irrelevant because the Fed is a totally Dependent Creature—as are we all in this highly regulated political environment. We must speak correctly, we must invest correctly, we must be correct on our identification of the soldiers of terror. We are all now quite correct, are we not? A riddle? Yes. A Mystery? Yes.
Mr. Prime Minister: we need an Enigma Machine to read the Fed’s Code. Please re-open Bletchley Park and start cracking it for us.
The troubling antics of the remaining three contenders for each party’s Presidential nomination have forced me to detour from postings on Ecomentary.com far too long. Governance issues have been capturing my full attention. Let’s direct some comments to their economic policy recommendations.
Each candidate speaks of doing something for those who feel underserved or even left out of the economic benefits our economy creates. Their substantive proposals amount to two sorts of “cures.” One is to blame someone or a class of “someones” for poor economic outcomes and the other is a continuing advocacy of ‘once size fits all’ remedies—more government intervention. Actually, all three wish to use the government to “do something,” with little or no recognition that government interference is not costless to economic growth. On the contrary, increased regulation has undoubtedly contributed significantly to lower economic growth. A smaller pie, even if redistributed, is not a winning economic strategy.
The two Democrats, Clinton andSanders both argue for more government intervention, more regulation and heavier taxation (albeit more “progressive”). Trump also argues for government intervention. He wants to punish the Chinese and other “foreigners” for American job losses. He even wants to punish American firms who relocate production overseas. Traditional Republican support for free trade has been eviscerated, free traders have little to choose between the two parties. Restricting trade is a sure fire method to reduce growth.
One expects Democrats to try slicing up the economic pie and redistributing it to pay off the various political minorities and interest groups that Democrats depend upon to win public office. By assigning much of the blame for the 2007-2008 financial meltdown to greedy bankers, evil mortgage companies and mortgage brokers and other profit seeking financial intermediaries, Democrats don’t look deeply, if at all, into the role played by much faulted government housing policies. They continually advocate more regulation, not less. Meanwhile, instead of attacking the increased interference and regulation that deters the formation of new business enterprises, the Trump response is that voters need to pick a Winner instead of sticking with Democratic losers. Is that a policy prescription or a denial of how the economy actually works?
Neither side seems to understand that government intervention and regulation does not offer a free lunch. They seem totally unaware that the already well-laden Regulatory State costs the US substantial economic growth. Obama always argued that the US needed to become more like Europe. He succeeded beyond all measure. The US has more regulation and lower growth. Welcome to Europe, voters!
Of course, if you think that the economic pie has been distributed “unfairly,” you probably don’t focus on how to bake a larger pie. You might not even think that regulation can affect how fast the economy grows. Former President Reagan’s remark that “Government is not the solution; Government is the problem,” has long since been forgotten, even by some claiming to be market- oriented Republicans.
In recent years, however, a number of economists have been focusing on the costs of regulation and how regulation can slow and undoubtedly has slowed U.S. economic growth. When the question is, How much does a reduction in annual growth of say 1% per year actually cost the US, when that reduction continues over say a thirty five year period, the cost is staggering. A bigger pie was available, but increased regulation destroyed a much better outcome.
A recent study published on the Mercatus.org web site (“The Cumulative Cost of Regulations,” by economists Bentley Coffey, Patrick McLaughlin, and Pietro Peretto) provides some insight. They estimate US economic growth was lowered by 0.8% per annum as a result increased regulation. Putting it more graphically, they find our economy would be 25% larger today than it actually is —-even if the costs per annum were as small as 0.8% per year. We conjecture that the annual costs might well exceed 1%.
There are many studies that show that the current level of reporting now required under environmental, health care and labor regulations pose a heavy cost burden for new, small businesses. New business formation lags in spite of very low interest rates. Yet, it is widely understood that real economic growth comes from precisely this segment of the economy. It is also well noted, but yet unexplained, that business investment in plant and equipment has been unpredictably sluggish. Perhaps, our declining productivity trends are not just accidents due to “slower innovation.”
These are subtle arguments but none of the candidates care or perhaps are even aware of them. They have missed the truism that a little hole in the dike can be as bad as a large one, given sufficient time. Time makes water a very powerful cumulative force. Similarly, even small decreases in annual economic growth can cumulate to a very large reduction in actual output. Increasing regulation works the same way and the US economy is badly under achieving.
It will be hard to punish the “foreigner” for our own failings. Punishing our own business sector can only worsen the problem of inadequate growth. The first step in getting well must be a proper diagnosis of our growth disease. We become our own worst enemy when we listen to the Siren calls for more regulation by the current candidates.
During the Bernanke era, the FOMC made strides to create more transparency about the intended course of monetary policy. This was done with the view that monetary policy changes should be better understood by the public (the markets), and that this understanding would give both transparency of Fed actions but also that monetary policy itself would be more effective by making that policy more transparent.
In fact, the so-called “Woodford Doctrine,” elucidated at an earlier Jackson Hole conference (August, 2012), seemed to imply that the Fed actually possessed an additional weapon in its tool arsenal by communicating its long run policy guidelines. Woodford, of course, had advocated a simpler guideline, nominal GDP, to avoid potential situations of conflict between the explicit dual mandate of output and inflation. Woodford felt sticking to the guidelines was a powerful weapon for the Fed.
Given the dual mandate of output (employment?) and inflation, Woodford’s prescription should have given the Fed a kind of channel within which the Fed could and should operate. He did allow for the ambiguity of potential conflict between the two targets but long term guidance was not to be disturbed without clear indication that something very fundamental had changed: No surprises; clear intentions: longer run predictability of actions. Who really could argue with that?
Rumor has it that the ”adult at the party,” was less clearly disposed to accept this as a guidance criterion for the Fed. Fischer’s approach at Jackson Hole 2016 (See Ecomentary.com “Off the Table-On the Table: the Fischerine Query,” August 31 2015) seemed to imply that no firm channel existed or was even desirable. Some critics of Fed policy could note that the dual mandate criteria might well be insufficient as a guideline of Fed future policy. It appears to this observer that Fischer has had his way at the FOMC meeting of September 17, and the ambiguous statement of policy intentions contained in the Yellen Press Conference following the FOMC meeting that day is now the name of the game.
The press conference walked away from the dual mandate criteria and introduced external economic conditions as a compelling reason for the Fed to “wait a bit longer” before implementing its first dose of a return to monetary policy normalcy. It is to be noted that only a solitary dissent by District bank President Jeff Lacker accompanied the decision. To this observer the title of “adult at the party” has changed hats!
Bernanke’s view of transparency to which the market thought Yellen had subscribed was that abrupt and uncommunicated policy shifts were nugatory at best, damaging at worst and clearly not effective forward policy guidance. While Bernanke didn’t subscribe to an iron-clad rule (such as one of the versions of John Taylor’s rule or Milton Friedman’s percentage growth rule) it seemed reasonably clear that long term guidance for Bernanke implied the use of the same criteria for FOMC policy shifts, meeting to meeting unless something extraordinary had occurred. Bernanke didn’t exclude the possibility of discretionary actions from its long-term guidance—in the event of striking and unexpected developments in the economy—but it was clearly an attempt by Bernanke to place a bridle on a potentially bucking horse in monetary policy decisions. Where a decisive change in policy had to be installed, it would be in the context of full public pronouncements that the rules of the game had changed from a sharp and unexpected shift in economic conditions. Now comes the Yellen-Fischer concern with American financial policy in light of world developments that were widely known well before the FOMC met on September 16-17.
What’s gone wrong here? First, all of the reasons that Yellen cited for her “patience” policy had long been in the market. China, emerging market fragility, poor growth in Europe were not new conditions. They had been talked about at Jackson Hole and by market observers for many, many months. Meanwhile, the unemployment rate—with all of its weakness as a measure of labor market conditions—was steadily declining; and, Yellen herself had spoken of her wish to view labor market conditions in a larger perspective. As for inflation, the FOMC had said and continued to say that despite very recent deterioration from the 2% criterion, it fully expected prices “in the medium term” to rise up to the 2% target.
While various market reporters had signaled only a 50% probability as to the likelihood of a Fed rate increase, the reaction of equity and bond markets was one of shock. Clearly, the public as a whole had been conditioned to expect that the ‘return to normalcy’ was about to begin. The S&P fell sharply following the widely expected “return,” and world wide markets (closed at the time of the announcement on the 17th) rattled down decisively the next day. Anytime the Fed thinks that world wide conditions are very frail, the market is bound to think the Fed knows something that the market doesn’t know. Could it be that the FOMC with all of its expertise and adults at the party doesn’t know the impact of disappointed expectations? Does the FOMC think that equity markets are a bubble that needs pricking?
What Yellen accomplished at the FOMC meeting and subsequent press conference seemed to violate the long-standing transparency rules that the Fed once had! To put it differently, it was a MISCOMMUNICATION, and that is a polite description.
A more sober assessment is that the market can no longer take the Fed as following its previous communications policy. This Fed is not transparent. It has undermined any credibility that the Bernanke era gave it. The Bernanke rule was really the following: set a course (for the Central Bank); stay on the course in order to anchor expectations in the financial market; deviate only if extraordinary events begin to change that have threatened financial stability. It was a “rule by exception, and the exceptions should be few!
Nothing major has occurred either overseas or in the U.S. except the perpetuation of known trends. Therefore, the market’s expectation of a first rise in the target rate coupled to a trajectory of very slow normalization was “in the game.” The Fed changed its rules. It has miscommunicated. By doing so it may have dislodged its carefully placed anchor.
Investors beware. We are back to a pre-Bernanke Fed—to a world of possible, unexpected shifts in policy. Build more uncertainty into your market forecasts. The Fed has told you to expect less forward guidance that can be relied upon and more (whimsical?) policy making under the guise that the “U.S. is not an island.” We are back to the Greenspan days with its mumbled pronouncements.
1) Monetary policy has two goals: maximum employment and stable inflation. Policy at any moment of time requires the assessment of where the economy is and where it is likely to go. That assessment is clouded by the inability to specify how much unemployment is cyclical and how much is structural. If the former, possibly it can be treated with monetary policy instruments. If the latter, it is beyond the Fed’s reach.
2) The inflation target has essentially been reached but the Chairwoman, still thinks there is “slack” in the labor market. She concedes that the differentiation between cyclical and structural unemployment is hard to make, but looking at the plethora of indicators in the labor market, she feels that the current level of (monetary) accommodation, is appropriate, particularly in view of the scheduled run off of central bank purchasing of Treasuries and MBS.
3. The difficulty with this assessment is that judging labor market conditions is at best extremely difficult. Forecasting how a continuation of the current policy target will affect labor markets in the future may beyond the Fed’s capability. Certainly, no single labor statistic is sufficient while how to mix them for maximum forecasting is not without controversy. She hints at the research going on within the Fed on a ‘factor’ analysis, but that will not convince markets in the short run
4. Fed guidance in such circumstances is unclear. Worse, using a potpourri of labor market stats will probably confuse markets more than it will enlighten them. Sometimes too much information overpowers common sense.
5. Ad Hoc tinkering or policy rules? At the end of the day, the larger issue of whether to base future policy on statistical babble or to adhere to a well understood policy rule is not treated in this speech. This Fed continually runs away from establishing a clear rule—one that markets might be able to discern
Markets will glean little from this speech. Equity and fixed income markets will continue to oscillate in the absence of clear central bank guidance and the troubling geopolitical events of the day.
What went wrong?
The causes of the financial meltdown of 2007-9 continue to be researched and debated by macro economists and financial analysts. It is likely to be years before a definitive analysis becomes widely accepted. Despite that debate, at least one antecedent to that disaster is present in nearly all explanations: government policy measures over many years to expand subsidies to owner occupied housing for poorer Americans were plagued by faulty incentives.
These incentives had very malign consequences for the financial sector of our economy. Under appreciated risks arising from poorly documented mortgage applications grew prodigiously. Mortgage companies were incented to write mortgages for individuals who could neither afford their ultimate financial obligations nor often understand them. Wholesale funding of such faulted mortgages received huge support from monetary policies that promoted world-wide yield searching. Credit rating agencies were suborned by the profitability of creating triple-A credit ratings for mortgage backed securities. Regulations that required many institutional investors to buy only securities with triple-A ratings created disastrous portfolio incentives. GSE’s were incented to expand their guarantees of subprime and Alt-A mortgage paper. Without question, short run political objectives overran prudential common sense.
Thoughtful observers of American political economy should be alarmed how the politics of subsidizing the “poor” to acquire housing is ‘back in the game.’ While no one has demonstrated that weak mortgage underwriting standards truly work to reduce long term poverty, appearing to make more credit available to individuals and families that they may not be able to support has undeniable voter appeal. Politicians operate on a short run electoral cycle. Faulty incentives are ignored or buried under political rhetoric.
In the aftermath of the financial panic, tightened standards on mortgage underwriting were the order of the day in 2011. Regulators insisted on a minimum of a 20% down payment or lenders had to retain a minimum of 5% of the loan if the loan was resold to investors. Prior neglect of such incentives had resulted in a serious financial disaster. It appeared that policy makers were moving in the right direction by focusing on inappropriate incentives for poor financial behavior. Sadly, this reform diet has now proven to be too strict for politicians who observe what appears to be an inadequate restoration of the housing sector. The result is bad incentives for mortgage underwriting are back in play.
Under the new compromise, regulators won’t require a minimum down-payment (20% goes to 0%), and broad exemptions for banks and mortgage issuers to retain portions of these securities will be granted. (Ziebel and Ackerman “Softened Mortgage Rule Advances,” WSJ 6/11/2014). Policy memory seems short indeed. Whatever failures there have been in not modifying many of these defaulted mortgages, remedies for housing’s slow recovery ought not to center on creating bad incentives once again in mortgage underwriting.
Washington now apes the Bourbons of pre-revolutionary France. “They learned nothing and forgot nothing,” said Talleyrand, some forty-odd years after the catastrophe of the French Revolution. With ultimate policy discussions driven by electoral politics rather than sound economic analysis, it is truly remarkable that current-day academic macro economists continue to research the real causes of the Great Recession. Even if economists come to a widely accepted conclusion, it is highly doubtful that policy makers will care, much less alter government policies to prevent such debacles from again occurring. Plus ça change, plus c’est la même chose.
Today, the FOMC finally got around to initializing the “taper.” It reduced the purchase of mortgage related securities by five (5) billion dollars beginning in January 2014 and a like amount of Treasury securities. Purchases in January will drop to $35 billion of mortgage securities and $40 billion of long term Treasury securities, (a total of $75 billion) while the Fed’s balance sheet continues to grow by those amounts as principal repayments will also be re-invested and the policy of rolling over maturing Treasury securities is continued.
The Committee said that economic activity is expanding at a moderate pace and that there has been further improvement in labor market conditions. At the same time, there is no strong evidence of rising inflation or inflation expectations. Since inflation is still well below the Committee’s target of 2.0%, and unemployment at 7.0% is well above its target of 6.5%, there is no rush to raise the Federal Funds rate. In fact, based on the forecasts presented by the 17 members of the Committee, as measured inflation is well below what the Committee feels is appropriate, the Chairman indicated that the accommodative stance of monetary policy is likely to be continued well into 2015. The lengthening of forward guidance is a kind of Bernanke “Twist.”
With the Funds rate at the zero bound, the usual tool of monetary policy (interest rate changes) is inoperative and that has given rise to Fed balance sheet expansion via these asset purchases and at the same time, a policy of forward guidance to markets that the Funds rate is unlikely to rise for a considerable period. Lessening the magnitude of asset purchase—and likely further drops in asset purchases in the forthcoming year—has created a need to re-assure debt markets that a return to normal, interest rate based monetary policy is a long way off. The Chairman stressed the dependency of this forward course on continuing improvements in macroeconomic data and at the same time allowed for a reversal of the “taper” if as yet unforeseen and untoward macroeconomic data begin to show up. Thus the magnitude of the taper and its future amounts is not set in stone. It is “data dependent.” In the Chairman and the Committee’s view, monetary policy is still quite accommodative, both from the point of view of continuing to add to the Fed’s balance sheet, but more importantly by the very size of that balance sheet that weighs down interest rate rises. The market seemed to accept these statements at face value, as there was very little upward drift at the longer end of the curve. The 10-year rate moved about 5 basis points, while the equity market boomed hugely. (S&P 500 up 1.66$%, Dow 30 up 1.84% and the NASDAQ -100 up 1.16%). In effect equity traders cheered then end of the “taper uncertainty.” The vote on the Committee for these policies was nearly unanimous, with the exception of Rosengren of the Boston Fed who felt the unemployment rate was “still elevated and well below the target.”
The new Committee forecasts show improvement in the expected range of 2013 and 2014 growth rates, while the anticipated unemployment rates were lowered in each of the years stretching out to 2016. Expected inflation (as measured by the PCE index) was expected to fall slightly stabilizing at 1.7 to 2.0% in 2016. Core PCE was not expected to be much different (the lower end of the range was raised by 0.1% in 2014 (to 1.4) and again in 2016 (to 1.8). Each of the years 2013 through 2016 was lowered from the September projection.
BB’s Press Conference
As I watched his press conference, I was struck by his comfort and his mastery of the data, the policy debate and his complete ease in answering each of the questions. Bernanke is well known as a baseball fan. Today, he was definitely on his game.
The “twist” he has underscored is not written in stone and it is not a pair of handcuffs on the incoming Chairperson. Data dependency is still in play, however he noted that Janet Yellen was in concordance with the entire statement and the underlying measures that are reflected in the wording. Bernanke has one more meeting as Chairman, and if the data continue to improve (or at least not worsen), it is likely that more tapering will be voted in that meeting. What the future pace of tapering might be once Yellen assumes the Chair is speculative at this point. Furthermore, there will be new members of the Committee surely by February, probably including Stanley Fischer, the former Chairman of the Bank of Israel and Deputy Manager of the IMF. Fischer’s likely relevance is that he has reportedly commented that he is not terribly in favor of strong “forward guidance” as he finds that the predictive power of Central Banks is not sufficiently great, particularly at long intervals. What a Yellen-Fischer combination is likely to do to forward guidance and the pace of tapering will be the next uncertainty faced by equity and debt traders. Today, it was all cheering. Next year may be different
Perhaps the most interesting answer given by Bernanke in the press conference was in answer to the question of why it is with all the measures taken by the Fed that growth has not resumed its former long term tendency and even more important, that unemployment is still far in excess of recoveries in past recessions. Bernanke pointed out that first, fiscal policy has been part of the extreme headwinds, certainly over the past year and that other uncertainties such as the banking issues in Europe have not yet created the growth push of a normal recovery. He pointed out, for example, that in the prior recovery, State and Municipal employment rose about 600,000 while in this recovery, public employment was down some 400,000. A million less public jobs has made reducing the unemployment rate much more difficult. In his closing remarks, he reiterated the William Mcchesney Martin adage of the Fed being “independent within the Government,” reminding critical Congressmen that Congress writes the rules and the Fed is charged with carrying them out. Clearly, Bernanke meant to assuage some of the more vociferous advocates of “audit” and “control of the Fed” in saying that Congress certainly has the right to ask questions of the Fed and to set the ground rules for Fed targets. He did not get into the “audit the Fed” controversy but he clearly has still one more Hill to climb and surely hopes that it won’t be an ordeal
Interest sensitive equities got spanked yesterday as a “good” growth report shook the equity and bond markets again. Another example of good news becoming bad news for investors and renewing an already enlarged focus on what the Fed will do the next time the FOMC meets. Markets have become inconsistent with common sense but in that inconsistency, there are guided by a Fed that is “inconsistently consistent.” Continue reading
Joseph Nacchio, former CEO of Qwest, recent release from prison evokes memories of the various financial fiascos in the communications industry during the Enron Era.1 While current news seems focused on his remarkable physical condition achieved during his nearly four years in prison, there is also mention of Nacchio’s contention that the SEC’s case against him for securities fraud was motivated by his refusal to grant NSA access to Qwest phone records following the events of 9-11. The exposure of Prism, the NSA’s gigantic communications surveillance program, through revelations by defector Edward Snowden, has re-opened comment on why the SEC went after Nacchio in the first place. Nacchio was charged and convicted of insider trading following disclosure of some $52 million of sales of Qwest stock whose market value suddenly plunged after his sales. His defense at the time was that the government came after him when he refused NSA’s request for phone records. Continue reading
Five year anniversaries can be joyful or sad. It all depends upon what one is celebrating. Undoubtedly, “extreme greens” must be dancing as five years have gone by due to their efforts to prevent the creation of the XL pipeline extension. A sober consideration of this dubious achievement reflects well on the Administration’s effort to reward environmental lawyers for their resolute pursuit and personal economic benefit of ‘keeping the world cleaner.” The facts don’t support such a claim, but if you have already made up your mind on what the true goal of the effort might be, ‘don’t confuse the issue with the facts.”